The Cost of Counterparty Risk and Collateralization in Longevity Swaps

Biffis, E., Blake, D., Pitotti, L. & Sun, A. (2016). The Cost of Counterparty Risk and Collateralization in Longevity Swaps. Journal Of Risk And Insurance, 83(2), pp. 387-419. doi: 10.1111/jori.12055

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Abstract

Derivative longevity risk solutions, such as bespoke and indexed longevity swaps, allow pension schemes, and annuity providers to swap out longevity risk, but introduce counterparty credit risk, which can be mitigated if not fully eliminated by collateralization. We examine the impact of bilateral default risk and collateral rules on the marking to market of longevity swaps, and show how longevity swap rates must be determined endogenously from the collateral flows associated with the marking-to-market procedure. For typical interest rate and mortality parameters, we find that the impact of collateralization is modest in the presence of symmetric default risk, but more pronounced when default risk and/or collateral rules are asymmetric. Our results suggest that the overall cost of collateralization is comparable with, and often much smaller than, that found in the interest rate swaps market, which may then provide the appropriate reference framework for the credit enhancement of both indemnity-based and indexed longevity risk solutions.

Item Type: Article
Additional Information: This is the peer reviewed version of the following article: Biffis, E., Blake, D., Pitotti, L. and Sun, A. (2016), The Cost of Counterparty Risk and Collateralization in Longevity Swaps. Journal Risk and Insurance, 83: 387–419., which has been published in final form at http://dx.doi.org/10.1111/jori.12055. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Self-Archiving.
Uncontrolled Keywords: longevity swap, counterparty risk, default risk, collateral, marking-tomarket
Subjects: H Social Sciences > HD Industries. Land use. Labor > HD61 Risk Management
Divisions: Cass Business School > Faculty of Actuarial Science & Insurance
URI: http://openaccess.city.ac.uk/id/eprint/15970

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